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Ratio Analysis

Sep 23, 2014

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Ratio Analysis. Chapter 6 Robinson, Munter, Grant. Learning Objectives. Identify situations in which ratio analysis is useful Understand the purpose of ratio analysis Calculate specific ratios Recognize limitations of accounting data in ratio analysis. Ratio Analysis.

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• balance sheet
• profitability ratios
• accounts payable turnover
• cash flow ratios quality

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Ratio Analysis Chapter 6 Robinson, Munter, Grant

Learning Objectives • Identify situations in which ratio analysis is useful • Understand the purpose of ratio analysis • Calculate specific ratios • Recognize limitations of accounting data in ratio analysis Chapter 6

Ratio Analysis • Cross-sectional and time series analysis • Controls for size differences • Controls for currency differences • Evaluate related components of different financial statements simultaneously • Ratios are easily (and commonly) modified Chapter 6

Ratio Analysis Categories • Activity (operations and asset management) • Liquidity (meeting short-term obligations) • Solvency (meeting long-term obligations) • Profitability (earnings and cost coverage) • Cash Flow (quality of earnings) • Price Multiples (stock price) Chapter 6

Activity RatiosHow day-to-day operations function • Inventory management • Inventory Turnover • Compares income statement and balance sheet amounts • Must average balance sheet figures ((Beg + End)/2) • Turnover = COGS/Average total inventory • Days inventory = 365/Turnover • How many days was inventory held before being sold? Chapter 6

Activity RatiosCritical operating cash accounts • Accounts receivable turnover • How many times a credit sale is made and subsequently collected • [credit sales/average accounts receivable] • May have to use total sales rather than credit sales • Consistency is important • Days receivable • Number of days between the charge sale and collection • [365/accounts receivable turnover] Chapter 6

Activity RatiosCritical operating cash accounts • Accounts payable turnover • Number of times a credit purchase is made and subsequently paid • [credit purchases/average accounts payable] • Often assume all purchases are on credit • Purchases = [COGS + Ending Inv. - Beginning Inv.] • Days payable • Number of days between credit purchase and payment • [365/accounts payable turnover] Chapter 6

Activity RatiosCash Cycle • Also a measure of liquidity • If low, small number of days in operating cycle to finance [Days inventory + Days receivable - Days payable] Chapter 6

Activity RatiosAsset Turnover • Long-term • Revenues generated by long-term assets • [Sales revenue/Average noncurrent assets] • Total assets • Efficiency of generating revenues given total assets • [Sales revenue/Average total assets] Chapter 6

Liquidity Ratios • Current ratio • Ability to meet short-term obligations • [Current assets/current liabilities] • Quick ratio • Remove less liquid assets • Keep cash, liquid investments, A/R • [(Current assets-inventory-ppd expenses-other)/current liabilities] • [(Cash+short-term investments + A/R)/current liabilities] Chapter 6

Liquidity Ratios • Defensive interval ratio • Compare 1 day’s costs to quick assets • [((COGS+SGA+RD)/365)/(Cash+short-term investments + A/R)] • For Motorola, defensive interval = .0075 • COGS = 21,445 • SG&A = 3,703 • R&D = 4,318 • Quick assets = 10,745 (6,082 + 80 + 4,583) Chapter 6

Solvency Ratios • Debt to assets: Total liabilities/Total assets • Proportion of assets financed with debt • Could include interest bearing debt only [(short term debt + noncurrent debt)/total assets] • Be aware that assets are recorded at historical cost, which may be different from current market value Chapter 6

Solvency Ratios • Debt to equity: Total liabilities/Total equity • A measure of how assets are financed • Or… (current debt + noncurrent debt)/Total equity • Examine relative sizes of debt and equity financing • Capitalization ratio: [(current debt+noncurrent debt)/ (current debt+noncurrent debt+total equity)] Chapter 6

Solvency RatiosCoverage Ratios • Adequacy of resources for meeting firm’s contractual obligations • Times interest earned • Can the firm cover its interest obligations? • (EBIT/Interest expense) • Cash interest coverage • (Cash from ops + interest paid + tax paid)/Interest paid Chapter 6

Solvency RatiosCoverage Ratios • Target a specific expense • [(EBIT+Rent expense)/(Interest expense+rent expense)] • Target principal on debt that is about to be repaid • [EBIT/(interest expense + principal payments)] Chapter 6

Profitability RatiosCommon-size • From chapter 5… • Income statement • Divide item of interest by sales • ROS = Net income/Sales revenue • Gross margin = Gross profit/Sales revenue • Balance sheet • Divide item of interest by total assets Chapter 6

Profitability RatiosReturn Ratios • ROA = Net income/Average total assets • Or, [(Net income + After-tax interest expense)/Average total assets] • Also, [EBIT/Average total assets] reflects pre-tax, pre-interest return Chapter 6

Profitability RatiosReturn Ratios • ROE = Net income/Average total equity • Return generated relative to the capital provided by the owners over time • Or, if firm has preferred stock [(Net income – Prfd dividends)/Average total common equity] • ROMVE = Net income/Market value of equity Chapter 6

Cash Flow RatiosQuality of earnings • Ability to pay obligations • CFO/Total liabilities • CFO = Cash flows from operations • Profitability (cash flow relative to sales) • CFO/Sales revenue • Cash return on assets • CFO/Average total assets Chapter 6

Cash Flow RatiosQuality of earnings • Cash flow-earnings index • CFO/Net income • Free cash flow ratio • CFO/Capital expenditures • If ratio>1, free cash flow exists Chapter 6

Price Multiple Ratios • Market’s valuation of a firm’s common stock • P/E = Share price/Earnings per share • Price/book ratio compares stock’s price to the recorded value of the net assets [Share price/(Book value of equity/Share outstanding)] • Price/sales = Share price/Sales per share • Also, compare price to cash flow per share Chapter 6

Ratio Integration DuPont analysis (decomposition) ROE = ROA x Leverage And more… Chapter 6

Ratio Integration ROA = Profitability x Turnover Chapter 6

Analysis • Generally compare 3-5 years • Requires 4-6 years of data • Balance sheet numbers may be averaged • Compare Motorola and Nokia • Activity • Liquidity • Solvency • Profitability Chapter 6

Activity Ratios Chapter 6

Liquidity Ratios Chapter 6

Solvency Ratios Chapter 6

Profitability Ratios Chapter 6

Limitations to consider • Historical cost of balance sheet items • GAAP vs. IAS rules • Accounting method differences • LIFO vs. FIFO inventory valuation Chapter 6

Summary • Calculate ratios • Decompose and interpret results • Understand limitations of ratio analysis Chapter 6

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• List of Commerce Articles

Ratio Analysis

Ratio analysis is referred to as the study or analysis of the line items present in the financial statements of the company. It can be used to check various factors of a business such as profitability, liquidity, solvency and efficiency of the company or the business.

Ratio analysis is mainly performed by external analysts as financial statements are the primary source of information for external analysts.

The analysts very much rely on the current and past financial statements in order to obtain important data for analysing financial performance of the company. The data or information thus obtained during the analysis is helpful in determining whether the financial position of a company is improving or deteriorating.

Also see: Advantages and Disadvantages of Ratio Analysis

Categories of Ratio Analysis

There are a lot of financial ratios which are used for ratio analysis, for the scope of Class 12 Accountancy students. The following groups of ratios are considered in this article, which are as follows:

1. Liquidity Ratios: Liquidity ratios are helpful in determining the ability of the company to meet its debt obligations by using the current assets. At times of financial crisis, the company can utilise the assets and sell them for obtaining cash, which can be used for paying off the debts.

Some of the most commonly used liquidity ratios are quick ratio, current ratio, cash ratio, etc. The liquidity ratios are used mostly by creditors, suppliers and any kind of financial institutions such as banks, money lending firms, etc for determining the capacity of the company to pay off its obligations as and when they become due in the current accounting period.

2. Solvency Ratios: Solvency ratios are used for determining the viability of a company in the long term or in other words, it is used to determine the long term viability of an organisation.

Solvency ratios calculate the debt levels of a company in relation to its assets, annual earnings and equity. Some of the important solvency ratios that are used in accounting are debt ratio, debt to capital ratio, interest coverage ratio, etc.

Solvency ratios are used by government agencies, institutional investors, banks, etc to determine the solvency of a company.

3. Activity Ratio: Activity ratios are used to measure the efficiency of the business activities. It determines how the business is using its available resources to generate maximum possible revenue.

These ratios are also known as efficiency ratios. These ratios hold special significance for business in a way that whenever there is an improvement in these ratios, the company is able to generate revenue and profits much efficiently.

Some of the examples of activity or efficiency ratios are asset turnover ratio, inventory turnover ratio, etc.

4. Profitability ratios: The purpose of profitability ratios is to determine the ability of a company to earn profits when compared to their expenses. A better profitability ratio shown by a business as compared to its previous accounting period shows that business is performing well.

The profitability ratio can also be used to compare the financial performance of a similar firm, i.e it can be used for analysing competitor performance.

Some of the most used profitability ratios are return on capital employed, gross profit ratio, net profit ratio, etc.

Use of Ratio Analysis

Ratio analysis is useful in the following ways:

1. Comparing Financial Performance: One of the most important things about ratio analysis is that it helps in comparing the financial performance of two companies.

2. Trend Line: Companies tend to use the activity ratio in order to find any kind of trend in the performance. Companies use data from financial statements that is collected from financial statements over many accounting periods. The trend that is obtained can be used for predicting the future financial performance.

3. Operational Efficiency: Financial ratio analysis can also be used to determine the efficiency of managing the asset and liabilities. It helps in understanding and determining whether the resources of the business is over utilised or under utilised.

This concludes our article on the topic of Ratio Analysis, which is an important topic in Class 12 Accountancy for Commerce students. For more such interesting articles, stay tuned to BYJU’S.

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Assignment Comparative Ratio Analysis of Two Companies

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